It's no secret that legal cannabis has the potential to grow into a big-money industry. After more than tripling sales over the previous four years to $10.9 billion, the State of the Legal Cannabis Markets report from Arcview Market Research and BDS Analytics believes a quadrupling in worldwide weed sales to $40 billion could be on tap by 2024.
With such impressive global growth forecast by Wall Street and analysts, it should come as no surprise that Canadian and U.S. marijuana stocks have been spending big bucks to get their piece of the pie.
Unfortunately, opening retail locations, bringing cultivation and processing facilities online, and setting up international infrastructure, isn't cheap, and cannabis companies have found this out firsthand over the past couple of years.
With capital hard to come by, issuing convertible debt has been fairly popular among pot stocks
Even following the passage of the Cannabis Act in our neighbor to the north -- the Cannabis Act legalized recreational weed in Canada -- most pot stocks haven't had access to non-dilutive forms of financing. This means the only way to effectively raise capital has been to issue common stock (as both a means to fund regular operating activity, as well as facilitate acquisitions) or issue convertible debentures. Although issuing stock has taken precedence, investors have certainly seen their fair share of convertible note issuances in recent years.
Issuing convertible debt -- i.e., debt that can be converted into shares of common stock by the noteholder or company at some defined point in the future -- holds one notable advantage for cannabis stocks: It pushes dilution down the road. Instead of exposing long-term investors to the immediate dilution caused by financing an acquisition with stock, or issuing stock to pay for normal corporate activity, convertible debentures come due years down the line, and they can be satisfied by either repaying noteholders in cash, or having the noteholders convert their debt into shares of common stock.
Understandably, converting these notes to shares will increase a company's outstanding share count and lead to dilution. But the point is that cannabis stocks are able to receive a healthy cash infusion without the immediate share price pressures associated with simply selling stock.
For example, Canopy Growth (NYSE: CGC), the largest marijuana stock in the world by market cap, did its shareholders a solid when it issued 600 million Canadian dollars of convertible notes (about $459 million) back in June 2018. Canopy's convertible debentures don't come due until 2023, and they provided the company, at the time, with a bounty of capital to fulfill its international expansion strategy and complete domestic capacity expansion projects. Canopy Growth has since netted $4 billion via an equity investment from Constellation Brands, but its convertible debt offering was the financing jump-start the company needed to really kick its expansion into high gear.
The debt demons are coming for Aurora Cannabis and Auxly Cannabis in Q1
However, convertible debt issuances have a downside. Namely, they need to be repaid or settled. If the share conversion price of a convertible note is considerably higher than where the company that issued the debt is currently valued, it becomes very likely that the company in question will have to repay said debt with cash upon maturity. In an industry where capital is still hard to come by, this creates potential problems. In the first quarter of 2020, two pot stocks -- Aurora Cannabis (NYSE: ACB) and Auxly Cannabis Group (OTC: CBWTF) -- could experience these problems firsthand.
Aurora Cannabis, the most popular pot stock among investors, issued a CA$230 million convertible note back in March 2018 that's set to come due in March 2020. The issue for Aurora is that the conversion price associated with this convertible note is CA$13.05. As of this past Wednesday, Aurora's shares were hitting the wires at less than CA$5 in Canada. Outside of an amendment to the conversion price, Aurora looks like it'll have no choice but to make good on repaying this debt due in March with CA$230 million in cash.
How will Aurora do that? That's the $64,000 question. The company did end fiscal 2019 with CA$172.7 million in cash and cash equivalents (not including restricted cash), and it does have $750 million (that's U.S.) available via a shelf offering. This shelf offering allows Aurora to issue stock or convertible debt over a 25-month period, should it choose. The point being that it's likely Aurora Cannabis is forced to dilute shareholders one way or another to rid itself of its CA$230 million convertible note.
Debt demons may also haunt Auxly Cannabis Group. Although Auxly does own, or have stakes in, a handful of cultivation or processing facilities, this was a company predominantly focused on cannabis streaming deals until mid-2018. These streaming deals required Auxly to provide upfront capital to other growers in exchange for a percentage of their output at a below-market cost. In other words, it was a capital-intensive business model that required Auxly to raise a lot of money.
In mid-January 2018, Auxly completed a CA$100 million convertible debt offering with a conversion price of CA$1.55 per share. This note is set to come due on January 16, 2020, and Auxly's share price is now CA$0.70 in Canada. If there is a silver lining here, Auxly announced last week that the TSX Venture Exchange had approved an amendment to its note that allows for the share conversion to occur at CA$0.74 instead of CA$1.55. On the flipside, this means even more shares potentially being issued to satisfy the conversion.
Auxly also has sufficient cash on hand to cover the value of the debenture. Last month, it closed a CA$123 million convertible debenture-based investment from global tobacco giant Imperial Brands, which essentially allows it to kick the can the down the road. However, this repaying this note in cash would eat up a lot of Auxly's available capital.
Suffice it to say that while convertible debenture issuances were all the rage for the marijuana industry two years ago, they could become the stuff nightmares are made of over the next couple of years.
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